The entire debate about the reg­u­la­tion of deriv­a­tives con­tracts takes on a new mean­ing in light of the OCC’s Quar­terly Report on Bank Trad­ing and Deriv­a­tives Activ­i­ties, Sec­ond Quar­ter 2009. The OCC (Office of the Comp­trol­ler of the Cur­rency) pub­lishes all sorts of inter­est­ing reports and hand­books that are largely over­looked by the media. And, the Deriv­a­tives Report is one of those OCC reports that almost no one seems to look at or care about.

For those read­ers who don’t know what a deriv­a­tive is Wikipedia has a great definition.

“A deriv­a­tive is a finan­cial instru­ment that is derived from some other asset, index, event, value or con­di­tions (known as the under­ly­ing asset). Rather than trade or exchange the under­ly­ing asset itself, deriv­a­tives traders enter into an agree­ment to exchange cash or assets over time based upon the under­ly­ing asset.”

Some deriv­a­tives are gar­den vari­ety exchange traded con­tracts that have an undis­puted legit­i­mate place in global finance. Stock futures like puts and calls are exam­ples of exchange traded deriv­a­tive con­tracts that aren’t par­tic­u­larly con­tro­ver­sial. Inter­est rate swaps (con­tracts that banks, investors, cor­po­ra­tions and indi­vid­u­als use to hedge move­ments in inter­est rates) are another exam­ple of deriv­a­tive con­tracts that have a long estab­lished legit­i­mate role in the global econ­omy. The same can be said for most con­tracts to hedge move­ments in cur­rency exchange rates.

How­ever, there are other types of deriv­a­tives con­tracts, such as credit default swaps, that War­ren Buf­fet has called “finan­cial weapons of mass destruc­tion” and which many econ­o­mists and com­men­ta­tors, myself included, think have a very lim­ited role to play in legit­i­mate busi­ness. The trad­ing of naked credit default swaps and com­mod­ity futures con­tracts that aren’t attached to an actual under­ly­ing deliv­ery of a com­mod­ity are con­sid­ered some of the “games of choice” for the U.S. casino society.

But if the U.S. has turned into a casino soci­ety, who owns the casino and how much is the casino mak­ing for its bosses?

As it turns out, the OCC Quar­terly Report answers my question.

From the OCC Quar­terly Report:

The notional value of deriv­a­tives held by U.S. com­mer­cial banks increased $1.5 tril­lion in the sec­ond quar­ter, or 0.7%, to $203.5 tril­lion.

U.S. com­mer­cial banks reported rev­enues of $5.2 bil­lion trad­ing cash and deriv­a­tive instru­ments in the sec­ond quar­ter of 2009, com­pared to a record $9.8 bil­lion in the first quar­ter.

A total of 1,110 insured U.S. com­mer­cial banks reported deriv­a­tives activ­i­ties at the end of the sec­ond quar­ter, an increase of 47 banks from the prior quar­ter. Nonethe­less, most deriv­a­tives activ­ity in the U.S. bank­ing sys­tem con­tin­ues to be dom­i­nated by a small group of large finan­cial insti­tu­tions. Five large com­mer­cial banks rep­re­sent 97% of the total bank­ing indus­try notional amounts and 88% of indus­try net cur­rent credit expo­sure. (empha­sis added)

Banks reported trad­ing rev­enues of $5.2 bil­lion in the sec­ond quar­ter, down 47% from the record $9.8 bil­lion in the first quar­ter. Notwith­stand­ing the large drop in trad­ing rev­enues, the sec­ond quar­ter per­for­mance was still the sixth high­est rev­enue quar­ter for com­mer­cial banks.

The OCC Quar­terly Report goes on to state that deriv­a­tive con­tracts are con­cen­trated in inter­est rate prod­ucts which make up 85% of the notional value of all deriv­a­tive con­tracts. On the other hand, credit default swaps only make up about 15% of the gross notional amount of deriv­a­tives con­tracts writ­ten by banks.

But, despite the rel­a­tively small size of credit default swaps they accounted for approx­i­mately 37% of the trad­ing rev­enue of all deriv­a­tives con­tracts. Inter­est rate swaps, despite being a much larger in size, accounted for only approx­i­mately 21% of trad­ing rev­enue from deriv­a­tives activities.

It should come as no sur­prise that accord­ing to the OCC, from 2003 to 2008 the credit default swap mar­ket grew at an annual rate of 100%, fell off in the first quar­ter of 2009 but has started to bounce back in the sec­ond quar­ter of 2009. After all, credit default swaps are among the most prof­itable prod­ucts for the banks that deal them. By the way, accord­ing to the OCC the top 5 banks con­trol approx­i­mately 93.5% of the mar­ket for credit default swaps.

So, who are these “top 5 deriv­a­tives banks”?

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I think that the hold­ing com­pany infor­ma­tion pro­vided by the OCC makes the sit­u­a­tion a lot clearer.

Accord­ing to the OCC “all other” includes 1,105 insti­tu­tions. The cat­e­gory of “all other” is almost irrel­e­vant to the market.

The next time that the debate on deriv­a­tives heats up and lob­by­ists argue that all deriv­a­tive con­tracts are great instru­ments for the U.S. econ­omy, keep in mind who has the most to gain from the sta­tus quo and who has the most to lose if deriv­a­tives are reg­u­lated and listed on an exchange. If all deriv­a­tives are listed and traded on an exchange, prof­itabil­ity for the deal­ers will plunge and markups charged by the banks will become trans­par­ent. Trans­parency and price dis­cov­ery seems to be great for every­one but the guys who are deal­ing these instru­ments and rak­ing in the big bucks.

When “indus­try experts” get on TV or tes­tify before Con­gress and say that it is every man’s unalien­able right to engage in naked deriv­a­tives trad­ing and that naked deriv­a­tives trad­ing isn’t the same thing as gambling…well, just think of the above charts and check out the lat­est OCC quar­terly report. You will be able to fig­ure out who wins and who loses from the casino economy.

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